Estimation of operational risk capital charge under parameter uncertainty

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Abstract

Many banks adopt the Loss Distribution Approach to quantify the operational risk capital charge under Basel II requirements. It is common practice to estimate the capital charge using the 0.999 quantile of the annual loss distribution, calculated using point estimators of the frequency and severity distribution parameters. The uncertainty of the parameter estimates is typically ignored. One of the unpleasant consequences for the banks accounting for parameter uncertainty is an increase in the capital requirement. This paper demonstrates how the parameter uncertainty can be taken into account using a Bayesian framework that also allows for incorporation of expert opinions and external data into the estimation procedure.
Original languageEnglish
Pages (from-to)51-63
Number of pages14
JournalJournal of Operational Risk
Volume3
Issue number1
DOIs
Publication statusPublished - 2008
Externally publishedYes

Keywords

  • quantitative risk management
  • operational risk
  • loss distribution approach
  • Bayesian inference
  • parameter uncertainty
  • Basel II

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